The federal budget will affect borrowing costs for everyone
As the GOP spending bill winds its way through Congress, the trajectory of U.S. federal debt, now 100% of GDP, is in the balance. What Congress and the president do with the finances of the U.S. government will seep out into the rest of the economy. Specifically, if the government must borrow a lot more, it affects the cost of borrowing for pretty much everyone else.
Recall the period before the pandemic when interest rates were super low. Where people were “borrowing money at 3 and 4% for commercial real estate transactions or a house,” said Alice Frazier, president of the 154-year-old Bank of Charlestown in West Virginia. “The low interest rate period was not a normal period.”
It was a dream, and we’ve woken up from it.
Rates were low back then for many reasons. Inflation was not an issue. Also, after the financial crisis, the Federal Reserve started keeping short-term rates low and working hard to push long-term rates down. And investors around the world were traumatized by the crisis and particularly interested in safe assets, accepting low rates for that purpose.
All of that has now changed. Inflation awoke, the Fed raised rates, and over time, international investors were less accepting of lower yields.
When borrowing costs rose, bankers like Frazier noticed.
“There was what I would call a pause,” she recalled, “and an assessment.”
Would-be homeowners started to think twice about that mortgage. “And on the business side there were investments, but our borrowers were much more measured, and this is operating type companies — landscapers or manufacturers,” Frazier said.
This is generally what happens when interest rates in the economy go up.
“Everything that the firm or the private sector would contemplate doing gets a little bit harder to do,” said Jesse Schreger, an associate professor at Columbia Business School.
Higher rates haven’t been fun, especially if you’re a buyer trying to get a mortgage, a startup trying to lure investors, or a struggling restaurant chain trying to stay afloat. But so far, the economy as a whole has been strong and able to handle it. Frazier said mortgage activity in her area bounced back to prepandemic levels.
“If you take a look, for instance, at consumers, at households, you know, we think they’re in a very sustainable place. Balance sheets are relatively healthy. The use of credit and leverage does not appear unsustainable,” said Josh Hirt, a senior U.S. economist at Vanguard.
“If you put it in a broad historical context, we have been higher than this before,” said Steve Laipply, global cohead of fixed income ETFs for BlackRock.
The 10-year Treasury yield is now under 5%. In the 1990s it hit almost 8%, and in the 1980s it reached north of 15%. There are upsides to high rates — if you have savings and invest them in bonds or what’s known as fixed income investments, you’re earning more on them. “For the first time in a number of years, you now have the ability to earn income in fixed income,” said Laipply, adding that many savers welcome this.
But the question right now is whether borrowing costs across the economy, after going up a notch since the start of the pandemic, are going to go up another, perhaps more unpleasant notch — and not just for the private sector.
“I think that really is gonna come down to the key question how are we going to manage our fiscal situation in the U.S.,” Hirt said.
“Our fiscal situation” meaning: How much more in debt is the federal government going to get. This is because when the government borrows more and more, it makes it harder for everyone else to borrow.
“You’re going to have more debt competing for the same dollars as private capital,” explained Kent Smetters, a professor at the University of Pennsylvania’s Wharton School. When investors have the choice between lending money to the government, or lending money to you, the safer bet is the government.
“They’re not gonna lend you a mortgage at a cheap rate when they can get a high interest rate lending to the government,” he said.
As the government gets more desperate to borrow money, it has to offer higher interest rates on its bonds. Everyone else has to pay even higher interest rates to compete, and sometimes they can’t. Certain loans or business investments will just not happen. Right now, the competition everyone’s facing from the government is looking like it’ll get worse.
“The U.S. is coming into this higher interest rate environment with just a staggering amount of debt outstanding that has to be refinanced at these higher rates,” said Schreger.
So it’s not just the debt the U.S. is going to take out, it’s the debt it has already taken out that will get renewed at higher rates. This will add further strain to federal budgets.
Depending on how things go, all of this extra borrowing at higher rates could push up borrowing costs.
“Unless Congress really gets its act together,” said Smetters, “there’s a chance that they could continue to stay at the current level for a few years, but then go up and so could double digit interest rates for mortgages be the new normal?”
Yes, he said, they really could.